Inherited IRA rules and regulations are unforgiving. An inherited IRA mistake reduces the distribution possibilities, resulting in potentially adverse tax consequences. When done correctly, however, an inherited IRA can provide years of additional income with the ability to spread and reduce the tax liability over the long term.
The rest of the inherited IRA story
After the last blog post, Have You Inherited an IRA? It’s Time To Compare Your Options, I quickly realized the need to address the inherited IRA rules and regulations. The questions generated, especially the “how to…” and “what about…” varieties, have been outstanding. Keep’em coming! Knowing the options available to beneficiaries of an IRA, and which one best suits your needs, are just part of the story.
What’s the point of expending your time and energy analyzing an inherited IRA strategy if you do it incorrectly? Here are 8 inherited IRA rules that could sabotage your strategy:
1. No Beneficiary
This rule is for the original owner of the IRA (or any qualified retirement plan for that matter). If an IRA doesn’t have a named beneficiary, the beneficiary defaults to the estate of the account owner, even if you’re the spouse. When that happens, you cannot use your own life expectancy to calculate required distributions.
If the IRA owner passed before April 1, the required beginning date (RBD), of the year after they turned 70½, you must distribute the entire IRA within five years. If they died after the April 1 RBD, then you can stretch distributions over the ACCOUNT OWNER’S remaining life expectancy.
The only hope you may have is if the IRA custodian has language in its agreement that indicates who inherits the IRA when there is no named beneficiary. Don’t rely on that possibility though, that’s the exception to the rule. Make sure you have an UPDATED designated primary AND contingent beneficiary for each account, and that they are on file with the plan administrator. Otherwise, your heir’s options may be limited.
2. Don’t Forget the Original Owner’s Required Minimum Distribution (RMD)!
If an IRA owner dies after reaching age 70½, but before April 1 of the next year, there is no required minimum distribution for the original owner.
However, if the IRA owner died after the April 1 RBD, an RMD is required. Check to see if he or she took their RMD. If they did, no additional RMD is needed. If they didn’t, then you as the IRA beneficiary must take that RMD by 12/31 of the year the original account holder died.
The RMD will be taxable income for the IRA beneficiary in the year received. If the beneficiary does not take the RMD, they are subject to a 50% penalty of the distribution not taken.
RMDs and RBDs can be confusing, but not something you want to mess up. A 50% penalty is harsh!
3. Inherited IRA Account Title
Unless you’re a spouse who chooses to Treat It As Your Own, the deceased owner’s name must appear in the inherited IRA title, as well as the beneficiary designation.
If John Doe passes away leaving his IRA to his daughter Jane Doe, the account should be titled something like, “John Doe (deceased June 2019) Inherited IRA FBO of Jane Doe, Beneficiary.” The deceased owner’s name and the words “inherited IRA” or “beneficiary” must be in there.
4. Contribution Rules
If you’re the spousal beneficiary and Treat It As Your Own, you’re allowed to contribute to the IRA (as long as you meet all other qualifications), because technically it is no longer an inherited IRA, it’s just a plain old IRA that’s yours.
Also, if you, the spouse, are the sole primary beneficiary of an IRA and contribute to the inherited IRA, including rollover contributions, or you don’t take the required distribution for a year as a beneficiary of the IRA, the IRA will be considered Treated As Your Own.
However, you cannot, under any circumstance, contribute to an inherited IRA if you’re either a non-spouse or spouse if there are multiple beneficiaries of the IRA. If you do so, even by mistake, it voids the inherited IRA. You cannot correct it, so don’t think that by taking the money back out everything will be okay. Once deposited, even if it’s only 25 cents, a complete distribution of the entire inherited IRA is required, and if it’s a traditional IRA, the full amount is taxable.
5. Transferring Funds
If you do not transfer the inherited IRA correctly, it will result in a deemed distribution, and the entire amount will be immediately taxable (if it’s a traditional IRA). The IRA must go directly, through a trustee-to-trustee transfer, from the deceased owner’s IRA to the correctly-titled inherited IRA.
However, a surviving spouse also qualifies for the 60-day rollover, which allows you to have the funds paid directly to you and then you may deposit them into a new IRA. So if a spouse is going to move the inherited IRA to their own IRA, they can move it over in this manner.
Non-spouses do not qualify for the 60-day rollover. My advice is to always do a trustee-to-trustee transfer in all instances. There is less chance of a mix-up.
6. Charitable Beneficiary
When the charity receives the IRA as a beneficiary, no income tax is payable. That’s the simple part. Potential problems arise when both a charity and an individual are primary beneficiaries. In this case, the charity must be paid its portion by September 30 of the year following owner’s death. If not, a distribution of the entire balance of the IRA must occur within five years, and you lose the ability to create a Stretch IRA.
If you want to name both charities and individuals as the primary beneficiaries of an IRA, make two IRAs – one for the charities and a separate one for the individuals. It allows you to accomplish your philanthropic goals while providing the individuals with all the beneficiary options without complications.
7. Multiple Beneficiaries
When an IRA has multiple beneficiaries, typically each one can choose the appropriate inherited IRA option for themselves, i.e., spouse vs. non-spouse. The key is to split the inherited IRA into separate IRAs for each beneficiary by the last day of the year following the year of the original IRA owner’s death.
They can also elect to forego setting up inherited IRA’s and just share the existing IRA. In that case, the age of the oldest beneficiary is used to calculate the amount of the distribution for ALL beneficiaries. This option is not typical nor recommended.
However, if an IRA has multiple beneficiaries without instructions on how to divide it, the shared inherited IRA is the only option. Let’s assume the ages of the beneficiaries of an inherited IRA are 65, 40, and 25, with no instructions on how to divide. The 65-year-old beneficiary’s life expectancy is used to calculate the distributions for all the beneficiaries, which would create a more significant distribution than would be the case for the 40- and 25-year-olds if they had inherited IRAs on their own.
So don’t forget, if you have multiple beneficiaries, designate what percentage each one will receive.
8. Inherited IRA – the Next Generation
The beneficiary of an inherited IRA can choose new beneficiaries when they take it over and select either the 5-year Inherited IRA, Stretch IRA, or Treat As Your Own option.
Treat As Your Own
If the surviving spouse Treats It As His/Her Own IRA, the beneficiaries of that IRA (assuming no remarriage) treat it as a non-spouse inherited IRA. The process of selecting the best inherited IRA starts all over.
Stretch IRA – Before RMDs
If you’re the spouse and you created a Stretch IRA, your beneficiaries can take distributions over their lifetimes if you die before your deceased spouse would have turned 70½.
Stretch IRA – After RMDs
If you created a Stretch IRA and you die after you start RMDs, whether you were a spouse or non-spouse of the original owner, then your beneficiaries of the inherited, inherited IRA, if you will, are required to take RMDs based on the life expectancy you were using.
Note the difference between a spouse Treating As Your Own and creating a Stretch IRA. That means your younger beneficiaries will have lost the chance to stretch the IRA over their lifetimes if you, as the spouse, chose the Stretch IRA instead of the Treat As Your Own option.
5-year Inherited IRA
If the beneficiary of an IRA creates a 5-year Inherited IRA and passes away before the full amount is taken out within the 5-year window, the clock is still ticking for the successor beneficiary.
For example, let’s assume Joe’s father passed away and Joe created a 5-year Inherited IRA. Joe passed away two years later without taking any distributions from the 5-year Inherited IRA. The successor beneficiary has three years left to distribute the entire IRA before the 12/31 five-year date.
Yes, another one of the complicated inherited IRA rules, but the point is that when you inherit an IRA, you get to select your beneficiary(ies).
Inherited IRA rules – the final word
The first step is to select the appropriate inherited IRA option best for your situation and goals. The second step is to ensure you follow the inherited IRA rules and regulations to enjoy the benefits of the first step, and this cannot be overstated. Income and tax consequences, not just for you, but also for future generations, are on the line.
Do you have any questions about the inherited IRA rules or any feedback you’d
like to share? I’d love to hear your thoughts, so please feel free to leave a
comment below so we can continue the discussion.